A lot of businesses choose their business form based on tax considerations. Specifically, businesses have the end goal of minimizing federal income tax and minimizing federal employment tax.
Federal Income Tax
There are four main types of tax systems that govern how business’s are taxed. They are Sub-K, Sub-C, Sub-S, and disregarded. For every type of business, there is a default rule applied (for instance, a Limited partnership is atomically taxed under Sub-K). However, nearly every type of business has the opportunity to opt for another tax system, if eligible. The “if eligible” is important, especially for Sub-S taxation. Many of the requirements to become a Sub-S business is fragile, and breaking one of the eligibility requirements automatically defaults to Sub-C. Below will discuss the differences between these tax systems.
Sub-K and Sub-S
Under Sub-K and Sub-S, the business can pass through it’s income to the owners. What this means is that the business will calculate it’s profits and losses. Any income the business makes will be divided amongst the owners based on the percentage of their ownership (this is true, even if the business retains that income to further the growth of the business). The owners then add that percentage to their income statement while filing their taxes and pay a percentage depending on the business income.
Sub-C
Sub-C businesses are treated as a separate entity, which means that they are required to pay federal income tax for all of their income. Assuming the business also distributes some of that income to the owners (usually through a dividend), the owners must report their reception on their individual tax statements. Thus, Sub-C corporations are double taxed (although the income is usually taxed at a lower rate).
Disregarded Entity
Single-Member LLCs are the only incorporated businesses that are treated as a single entity (much like a sole proprietorship). Unless they opt for Sub-S or C taxation (can’t opt for Sub-K), they report the business gains and losses on their individual tax returns.
Choosing Between Sub-K and Sub-C
Tax Allocation
Owners can determine who shares most of the burden of the tax. However, this is quite complex and subject to ensuring that the allocation has a substantial economic effect. For instance, if one owner is in a higher tax income and the other is in a lower tax income, and the business anticipates losing money in that year, the owners can allocate the losses more to the owner in the higher tax bracket. This means that the tax deductions are going to be higher and decreases the burden on the individual tax returns.
Federal Employment Tax
An owner that is categorized under a Sub-S has to pay FICA (Social Security and Medicare) for itself and employees. However, owners categorized under Sub-K are subject to self-employment tax “SE tax” which is means that the owner is subject to paying all (not just half) of the tax (in Sub-S, the business only pays half).
However, this presents an issue for those who abuse the system. You see, under this system, a business could provide a small salary, but provide large compensatory benefits. This means that the individual has a lot lower reported taxable income. If suspicious, the IRS will audit this amount to determine if the salary is unreasonably low.
Watson v. Commissioner
668 F.3d 1008 (8th Cir. 2012).
Watson lost and appealed.
Question
Was Watson’s salary reasonable compensation?
Rule
The court considers:
- The qualifications of the individual
- How much the individual works
- The gross earnings of the employer
- The salary compared to others in a similar capacity
- Comparing the salary alongside other compensatory benefits paid to the individual.
Holding
Watson was tax deficient and the judgment is affirmed.
Facts
Watson went to school and graduated with an accounting degree. He then worked for about twenty years gaining experience as an accountant and specializing in taxes. He became a partner at LWBJ and then later left, formed DEWPC, and then DEWPC took his place as partner in LWBJ.
Previously, Watson was not paid a salary because the company did not have the cash flow to pay him. In 2002 and 2003 the company paid Watson 20,000 and then paid DEWPC roughly 200,000 in compensation which was then dispersed to Watson. Upon investigation, the IRS determined that Watson had avoided the FICA tax and obtained a tax deficiency judgment against him, saying his salary should be been about 91,000 instead of his 20,000.
Analysis
Considering the factors above, the salary paid to Watson was unreasonable compensation. He went to school, worked full time, made a lot of money for the employer, was paid considerably less than others in his capacity, and his salary was disproportionately low compared to his other compensatory benefits.
Takeaway
Become a Sub-K corporation if you want to allocate percentage of ownership (as long as there is a substantial economic effect). Or, become a Sub-S business if you want to reduce employment taxes, but be careful of under compensation of a salary.
Disclaimer
The content contained in this article may contain inaccuracies and is not intended to reflect the opinions, views, beliefs, or practices of any academic professor or publication. Instead, this content is a reflection on the author’s understanding of the law and legal practices.
